Monday, August 5, 2013

Projecting the unemployment rate

Back in June, the Fed had made it quite clear that the FOMC is looking for the unemployment rate to hit 7% before fully ending the current securities purchase program. The bank still continues to be focused on this headline measure (even if it's not always a meaningful indicator of the health of the labor markets).

CNN: - If unemployment falls to 7% by mid-2014, the Federal Reserve will stop buying U.S. bonds and mortgage backed securities, he said. That's the first hard number the Fed has given for when it may end its stimulus policy, known as quantitative easing.

The July unemployment rate came in at 7.4%. The question now is - how long would it take for the number to fall another 0.4% ?

It comes as a bit of a surprise to many, but the decline in the unemployment rate since the peak in 2009 has been remarkably linear. And a linear projection puts the 7.0% unemployment rate in Q1 of next year.

That means if the Fed starts curtailing its purchases in September, the monthly reductions will need to be around $14 billion to hit that target. Of course another very realistic scenario is that the decline in the unemployment rate will slow. In that case we could see the target rate reached in Q2, 2014, making the monthly reduction requirement more gradual. What is clear is that the Fed does not want to spook the markets by suddenly ending the purchases. That makes the central bank more likely to start soon to make sure the FOMC doesn't end up with a 7% unemployment rate on their hands long before the purchases are wound down.

The 6.5% rate is supposedly the time the Fed is expected to consider raising the overnight rate. That date remains much more uncertain, since estimating the trajectory of the unemployment rate that far out is difficult to say the least. Right now the linear interpolation puts the 6.5% unemployment rate at the end of next year, while the futures market is putting the first rate hike in Q1 of 2015. That means that the futures market is not entirely inconsistent with the linear fit of the unemployment rate - even that far out.